I am a Capitalist Pig, and proud of it, thus you would not expect me to support government interference and more strenuous regulation of financial institutions – after all, capitalism (free markets) and tight regulation don’t mix well. Well, at the risk of been kicked out of the Capitalistic Pig Party, I am in support of tighter regulation of too-big-to-fail (TBTF) institutions – the likes of Citigroup (C),JPMorgan (JPM), Bank America, and (God forbid; after all, they are doing “God’s work” – their CEO’s words, not mine) Goldman Sachs (GS).

Lack of tight regulation in the TBTF space leads to the worst economic system of all: asymmetric socialism. The enormous gains are reaped by employees and shareholders, but losses are socialized and paid by taxpayers. That is simply immoral.

Letting companies fail is at the core of capitalism’s DNA, and I still stand by that. However, what we’ve discovered over the last few years is that if we let TBTF banks go bankrupt, their failure may take down other healthy (interlinked) financial institutions and derail the real (nonfinancial) economy. We saw glimpses of that about to happen when Lehman (LEH) went bankrupt. If the government hadn’t stepped in to guarantee money-market funds (and almost everything else on earth), the real economy would have stopped in a few days, with massive withdrawals of funds from money markets and a shutdown of the commercial paper market, which in turn would cut off healthy companies like IBM (IBM) from regular day-to-day activities like financing their inventories and paying their employees.

Our financial system operates on the assumption of continuity: we assume tomorrow will arrive and that we’ll be able to get our money out of the banks if we want to. A failure of large financial institutions is akin to an earthquake of magnitude 9 on the Richter scale taking place in NY, but with aftershocks of 7 magnitude ripping throughout the country; and at the end of the day (or the week) the whole country ends up in ruin.

I could be wrong, and the failure of a large bank might end up being not such a significant event, but we will NEVER find out, as the cost of being wrong is too high. So we end up with the imperfect world we live in – the big banks will not be allowed to fail.

This imperfect world leads us to two realistic solutions: (a) create incredibly strenuous regulations that will require significantly higher equity-to-debt ratios than for smaller banks and severely restrict the activities of TBTF institutions. Basically, they need to be turned into regulated utilities, like your local gas and water companies. Permit their “God’s work” to be limited to only very transparent traditional banking activities – so they cannot fail. Separate the leveraged hedge fund (the proprietary trading operation) and the bank (the institution that takes deposits and makes loans). In other words, bring back a more sophisticated version of Glass Steagall act.

Or we have option (b): break them up, either by making their lives unbearable through the strenuous regulation described in option (a), or simply by legislating it, as was done with AT&T (T) in the 1980s.

There are upsides and downsides with each solution. I personally believe regulations of complex systems often fails, as Wall Street always figures out how to game the system. Fannie (FNM) andFreddie (FRE) had a single regulator, OFHEO, whose sole job was to insure their viability. That didn’t work out well. Of course Fannie and Freddie also had a conflicting goal: they had to report to HUD that they were providing enough financing to low-income households. (Canada, on the other hand, is dominated by just a handful of very large banks that are strenuously regulated and were almost unscathed by the recent financial crisis.)

Breaking them up is what makes the most sense to me. Break them into small enough pieces that their failure becomes a non-event for the economy as a whole. That way failure will not be socialized, but borne by those who were to reap the rewards, rather than your regular Joe and Jane Six-Pack having to fork over a chunk of their paychecks to “bail out” the TBTFs so they can keep their jobs.

Intense regulation of TBTF institutions will slow economic growth, but to its natural, sustainable level. As we have learned, the other type of growth, though fun for a while, has a price tag that only increases with time.

Regulation may even stiffen innovation. I love innovation; I buy anything that has an “i” in front of it – I may even buy Apple (AAPL)’s iPad. But Wall Street and our economy as a whole would have been better off if, over the last decade, Wall Street was less “innovative” and employed fewer mathematicians with PhDs. Their latest & greatest innovations – the financial products that through sophisticated, ingenious, mind-boggling formulas (that often lacked common sense) showed their bosses how to create higher financial leverage on top of already high financial leverage – were responsible for the bombs that were at the heart of many recent blowups.

Breaking up TBTF will face the criticism that smaller banks will be less efficient and thus borrowing costs will be higher for consumers and corporations. This would be true if TBTF banks did not come with marble conference rooms, million-dollar executive offices, fleets of corporate jets, and $100-million compensation packages. The bottom line, if you compare the financial metrics: smaller banks are not any less efficient than the large ones.

A greater government involvement in the financial sector is not something I thought I’d ever ask for, but it has turned into a necessity in order to preserve, not destroy, capitalism.

Vitaliy N. Katsenelson

http://contrarianedge.com/

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).

Comments

I find it funny when people use the term "free markets" and "capitalism" in the same sentence.

I know of two definitions of capitalism. 1) John and Mary rent a store, bake cookies, sell them and make a living.(liberal capitalism) 2) Wal Mart gets cheap cookies from China, Under cuts John and Mary putting them out of business and then hires them in their Bakery for min. wage and no health care. (republican capitalism). Free markets are free for the hidden rich, not for guys like me. Teddy Roosvelt had it right.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.